Stochastic Correlation and Risk Premia in Term Structure Models

Posted: 29 Sep 2016

See all articles by Carl Chiarella

Carl Chiarella

University of Technology, Sydney - UTS Business School, Finance Discipline Group

Chih-Ying Hsiao

University of Technology, Sydney

Thuy Duong To

University of New South Wales, Sydney; Financial Research Network (FIRN)

Date Written: February 23, 2016

Abstract

This paper analyzes a term structure model that allows for both stochastic correlation between underlying factors and an extended market price of risk specification. We show that significant improvement in bond fitting and portfolio performance is obtained by the model. However, the restriction on market price of risk has a more negative impact on bond price fitting and forecasting, whereas the restriction on correlated factors has a more negative impact on hedging performance. The model has good predictive power for bond risk premia. Once our model factors are taken into account, other predictive factors become insignificant.

Keywords: term structure, stochastic correlation, risk premium, wishart, extended affine, multidimensional CIR

JEL Classification: G12, E43, C58

Suggested Citation

Chiarella, Carl and Hsiao, Chih-Ying and To, Thuy Duong, Stochastic Correlation and Risk Premia in Term Structure Models (February 23, 2016). Journal of Empirical Finance, Vol. 37, 2016. Available at SSRN: https://ssrn.com/abstract=2845132

Carl Chiarella

University of Technology, Sydney - UTS Business School, Finance Discipline Group ( email )

PO Box 123
Broadway, NSW 2007
Australia
+61 2 9514 7719 (Phone)
+61 2 9514 7711 (Fax)

HOME PAGE: http://www.business.uts.edu.au/finance/

Chih-Ying Hsiao

University of Technology, Sydney ( email )

15 Broadway, Ultimo
PO Box 123
Sydney, NSW 2007
Australia

Thuy Duong To (Contact Author)

University of New South Wales, Sydney ( email )

School of Banking and Finance,
University of New South Wales
Sydney, 2052
Australia
61295855865 (Phone)

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

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